Do British households have too much debt? Or to put it another way, do British households feel they have too much debt to allow them to start spending? On this question hang the prospects for our economic recovery.
Given the weakness of exports and business investment since the financial crisis, consumer expenditure is, mathematically, going to need to play a bigger role if we are to get any decent growth in the years ahead. The trouble is that consumers simply won't open their wallets if they feel they've got too much debt on their backs, even if inflation abates and incomes start to grow in real terms. Hence the question: are we overleveraged?
Opinions on the issue diverge. The Treasury's official forecaster, the Office for Budget Responsibility, seems to take the view that the great wave of household deleveraging is abating. It sees consumer spending coming in weak this year and next, but picking up nicely in 2015.
Much of our debt, of course, is mortgage borrowing. One event that would scupper the gradual pick-up scenario is a slide in house prices that would leave households feeling more oppressed by their debt pile. The OBR doesn't see this as a problem. Its forecast is for house prices to rise gently for the next few years, before picking up steam in 2015 (see the second chart).
However, not everyone agrees with this sanguine forecast. The International Monetary Fund, in its most recent comprehensive report on the UK economy, argues that deleveraging by British households probably has further yet to run. More ominously, it sees house prices as overvalued by between 10 to 15 per cent. Fathom Consulting also sees further deleveraging. "The end of the beginning" is how the consultancy describes our situation in a recent note.
There are plausible narratives on both sides. On the one hand, UK household debt has come down since the financial crisis, suggesting progress on deleveraging. It declined from 140 per cent of income in 2009 to just over 120 per cent last year, as the main chart shows. Also, the saving rate seems to be declining, falling from 7.9 per cent to 6.7 per cent in the final quarter of 2012, implying people might be feeling more comfortable about their net fiscal position.
On the other hand, household debt as a percentage of income remains well above historical averages. The UK household debt burden is still high by international standards. It is true that record low interest rates from the Bank of England help households to service the debt. The joint Bank/Treasury Funding for Lending Scheme will also probably assist in this respect by bringing down mortgage refinancing rates. There are restrictions on housing supply in the UK too, relative to other countries, which could explain our higher house prices and, consequently, mortgage debt. But those households still look fragile. If interest rates were to rise and wage growth was to remain subdued there could be trouble. Forbearance by lenders is very likely to be helping keep some people in their homes.
In the end it's impossible to know. Rather like the vexing productivity puzzle, the evidence base is simply not there yet to say with any confidence one way or another whether house prices are fairly valued, and consequently whether households are overleveraged. So, in a sense, the more important question, given the uncertainty, is: what is the best policy response to support the economy?
The Chancellor's state home-buying guarantees for first-time buyers with small deposits, announced in the March Budget, look irresponsible given the possibility that the housing market could well have a correction in store. A five per cent slide in house prices would put these new buyers in negative equity. A more prudent alternative to the problem of young families priced out of the housing market would be, instead, for the Government to boost the housing supply by sponsoring the construction of more homes.
More generally, the IMF's policy prescription looks sensible. It argued last year that with the possibility of further household deleveraging to come and also house price declines that the authorities should offer monetary and fiscal support to the economy. That means more quantitative easing from the Bank of England and a slowing of the pace of fiscal consolidation from the Government.
I would add that another policy imperative should be to clean up the balance sheets of our largest banks too. There is a mountain of survey evidence that these institutions are not lending to creditworthy small and medium size firms because their managements still have one eye on the un-provisioned toxic legacy loans on their books. It really is a disgrace that, five years after the onset of the crisis, ministers have still not fixed the credit supply.
The £25bn that the Bank of England has instructed private lenders to raise is too modest. As some members of the Financial Policy Committee regulator have pointed out, that will still leave £1.5trn of banking assets on the books of banks which are still very highly leveraged. It is difficult to see how such banks are going to support more lending to the economy.
But there is no disguising the centrality of the question of demand for credit in the coming years. It all comes back to whether or not those household debt piles are sustainable.